Small Business Taxes & ManagementTM--Copyright 2016, A/N Group, Inc.
We often talk about "income", but tax law recognizes a number of different types of "income". Some are general in nature, some specific to relatively narrow areas of the Code. The article below describes the most common ones along with a short discussion of related and nontax income definitions.
Total income. This is the starting point for individual returns, currently line 22 on Form 1040. It's comprised of wages, interest, dividends, income from a sole proprietorship, capital gains (and losses), income and losses from S corporations, partnerships, and trusts, rental income and losses, and distributions from qualified retirement plans.
Adjusted gross income. This is the workhorse of income definitions in the Code, at least for individuals. It's abbreviated AGI and many other provisions of the Code use it to define thresholds. It starts off with total income and from that you subtract various items such as IRA contributions, alimony paid, contributions to SEPs and other qualified plans, student loan interest, moving expenses, etc. AGI is the definition for determining the phaseout of itemized deductions and personal exemptions and a plethora of other phaseouts. For that reason a deduction "toward AGI" such as for a deductible IRA, is preferable to one "from AGI" such as for state and local income taxes, charitable contributions, etc.
Modified adjusted gross income. Abbreviated MAGI, it's the AGI determined above modified by one or more income or expense items. For example, the threshold for the net investment income tax is MAGI of $250,000. Here MAGI is your AGI plus any foreign earned income exclusion taken on the return. When computing the limitation for passive rental losses your MAGI is your AGI before any deduction for those rental losses. Thus, the computation of MAGI depends on the application.
Taxable income. Take your AGI and subtract your itemized or standard deduction and your personal exemptions to arrive at taxable income. This is the "money" number for determining your tax. We'd like to say you just go to the tax tables and find your bracket to compute the tax, but it's not that simple. If you have capital gains or qualified dividends, those will probably be taxed at a different rate.
Alternative minimum taxable income. Abbreviated AMTI it's your taxable income for determining the alternative minimum tax. For AMTI purposes you can't deduct taxes (real estate, state local income, etc.), interest on a home equity loan (unless used for home improvements) or miscellaneous itemized deductions. There's also an adjustment for medical expenses. There are additional adjustments for depreciation, interest on tax-exempt private activity bonds, net operating losses, and several other items. Business owners could run into several of these special adjustments.
Earned income. Basically, income earned from a job. Thus, it includes wages, salaries, tips, net earnings from self-employment, disability income reported on a W-2, and union strike benefits. It does not include interest, dividends, alimony, pensions, social security benefits, rental income, etc. The definition is important for determining contributions to some qualified plans. The definition is modified for some specific areas of the tax Code such as the earned income credit.
Self-employment income. The usual term is "net earnings from self-employment". It's the net income from a trade or business carried on by an individual as a sole proprietorship and an individual's distributive share, whether or not distributed, of the ordinary net income or loss from a trade or business of a partnership (including an LLC taxed as a partnership).
Investment income. It's income from property held for investment. That includes dividends received, interest, royalties, annuities, and gains from the sale or disposition of the property. It doesn't include interest income received from a trade or business activity such as interest on business accounts receivable. Nor does it include gains on property held for use in a trade or business (e.g., equipment). For the investment interest deduction it doesn't include qualified dividends or long-term capital gains.
Passive activity income (losses). This is income from certain activities. Rental activities are inherently passive. For example, the rental of that home you inherited from your mother. There are limited exceptions, the most notable for real estate professionals. Other activities may be passive or nonpassive. A trade or business may be passive to an owner if he or she does not materially participate in the business. For example, Fred owns 30% of an auto repair shop; his father owns 70%. Fred works 8 hours a day, 5 days a week in the shop. His father comes in on Saturdays for 3 hours. The income from the business would be nonpassive for Fred, but passive for his father.
Portfolio income. This is income such as interest, dividends, royalties, etc. received by a pass-through entity (S corporation, partnership) that's a trade or business. The income is segregated when computing the net income or losses from passive activities.
There are other definitions for other applications such as accounting and other tax purposes.
Revenue. This is gross sales before any deductions.
Gross profit (or income). Usually it's gross sales less cost of goods sold.
Total income. For tax purposes it's gross profit plus other income.
Operating income. For accounting purposes it's gross profit less operating expenses such as marketing, general and administrative, depreciation, etc. It doesn't include interest expense and gain or loss on sale of assets.
Net income before taxes. That's operating income less interest and gain or loss on the sale of assets.
Net income. The bottom line after deducting taxes.
Ordinary income. A generic term for income that's tax at regular tax rates. The alternative is income, such as capital gains, taxed at a special rate.
Other income. Business income is often split between income from the regular operations of the business and income from other sources. Other income could include court awards, lease inclusion amount for leased luxury autos, Sec. 481 change in accounting adjustments, recoveries of debts charged off in prior years, interest income related to business operations such as interest on delinquent accounts receivable.
Earnings and Profits. This is special "income" computation by a C corporation. It starts with income but is increased by tax-exempt income, proceeds of life insurance on officers, etc. Adjustments include depreciation (computed on a straight-line basis), cancellation of indebtednes income, etc. The object is to compute "economic income" that would be available for the payment of dividends.
The good news is that usually the "income" in use is clearly referenced in IRS forms, instructions, etc. Nonetheless, you should be aware that the definitions can differ. You should be careful to avoid using a generic term if you're referencing income in a buy-sell or other agreement. You're best bet is to reference a line on the tax return or include a definition in the agreement.
Copyright 2016 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 04/29/16